The Emergency Economic Stabilization Act ended the not so well well-kept secret of hedge fund managers, the deferred compensation arrangement with their offshore funds or as the New York Times described, “an unlimited Super IRA for the super-wealthy.” As Judge Learned Hand (of blessed memory to tax attorneys) once said “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes. Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)”
The addition of IRC Sec 457A effectively ended the ability of investment managers to defer tax recognition of the carried interest in the investment manager’s offshore fund. Most hedge funds operate using some sort of master feeder structure. The domestic fund and offshore funds aggregate assets into a single feeder fund. The offshore fund is generally available for foreign investors and U.S. tax exempt investors who invest in the offshore fund to avoid unrelated business taxable income (UBTI).
The typical fee structure provides for a two percent annual management fee and a twenty percent carried interest (read profits interest) for investment returns over an investment high water mark. Domestic funds were never able to defer the carried interest as the investment manager as domestic funds typically operate as pass-through entities.
Under IRC Sec 457A, hedge fund managers must repatriate the offshore deferred compensation not later than December 31, 2017. I personally am familiar with stories of hedge fund managers that have over $1 billion of offshore deferred compensation. IRC Sec 457A effectively eliminates the ability of investment managers to enter into deferred compensation arrangements with their offshore funds going forward.
After the all music and tears stop, is there any viable deferred compensation planning remaining for hedge fund managers?
This article will introduce an old concept that still has plenty of charm. In many respects, this technique is a better planning technique than the existing deferred compensation planning arrangement. After all, deferred compensation arrangements have tax problems, namely income and estate taxation that impose a whopping 70-80 percent “whack” on the deferred compensation assets.
Why does all of this matter now? First, a miracle will not fall out of the sky (at least for hedge fund managers) between now and December 31, 2017. Second, tax rates on both the income and estate tax fronts are headed upward. Third, the investment markets are not as generous as they once were. It is much harder to make money in the markets so it becomes even that much more important to minimize the impact of taxation.
The article will outline a technique that has been used for over fifty years in corporate America. Like anything else, time and treasury regulations have changed it from its original format. However, the planning power still remains.
Taxation of Offshore Investment Funds
Unless the income is effectively connected to a U.S. trade or business or subject to FIRPTA for U.S. real estate most hedge fund investment income will not be subject to U.S. taxation. Generally, the capital gain, interest and dividend income will not be subject to U.S. income taxation. However dividend income may be subject to a 30 percent withholding tax. The offshore corporation which is usually domiciled in Cayman Islands or another BVI jurisdiction is not subject to taxation in the domicile of incorporation.
Private Placement Life Insurance (PPLI)
PPLI is a customized variable universal life insurance policy that offers institutional pricing and unlimited investment flexibility. The policy can offer hedge fund and other alternative investments as part of the offering of funds within the policy.
The thrust of the deferred compensation arrangement is a split dollar arrangement. That’s it! Yes, that’s it.
Split dollar life insurance is a funding technique that has traditionally been used as a life insurance funding technique used by employers to provide life insurance coverage for key executives. The earliest reference to split dollar is Rev. Rul 55-713.
The split dollar arrangement is also coupled with a death benefit only (DBO) plan. The DBO plan provides for the payment of benefits to a designated beneficiary of the hedge fund manager at death. The designated beneficiary may include a family trust. This is an additional benefit above and beyond the split dollar arrangement.
The power of split dollar is how it is taxed to the participant. The participant is not taxed on the employer’s premium payment to a life insurance company but rather in one of two ways- the economic benefit method or the loan method- which will be described in detail below. Generally, the employee is taxed on the economic benefit of the death benefit provided to the employee.
Hence, an offshore fund could contribute $2.5 million in annual premium to a private placement life insurance policy (PPLI) insuring the hedge fund manager (assume age 50) and the manager would have current income taxation of $32,400 in Year 1 of the arrangement. This same amount would be treated as a gift for gift tax purposes in the event the hedge fund manager’s policy is owned by an irrevocable trust. A hedge fund manager resident in New York in 2013 would have current taxation of approximately $1.35 million without the arrangement.
The arrangement calls for the use of both split dollar methods – economic benefit and loan method. The split dollar arrangement uses the economic benefit method while the term costs remain low. When the economic benefit amount for tax purposes reaches an amount that makes the hedge fund manager say “ouch”, the arrangement is converted into a loan arrangement.
This technique is known as Switch Dollar. The four stages of Switch dollar are as follows:
Phase 1 - Economic Benefit Phase – The offshore fund (corporation) enters into a split dollar arrangement with the investment management firm to provide death benefit coverage for a select group of executives from the hedge fund in lieu of payment of the carried interest to the investment management firm. The amount of premium commitment under the plan is equal to the amount of forgone carried interest or some percentage of the carried interest.
In the majority of cases, the policy will be owned by a family trust. The trustee of the family trust will enter into the split dollar arrangement with the offshore corporation, and investment Management Company.
The offshore corporation funds the entire policy premium. The trial attorney has a tax cost equal to the value of the economic benefit (term insurance cost) for the trial attorney’s (Family Trust) interest in the policy.
Phase 2 - Switch – The split dollar agreement terminates when the economic benefit reaches a level that is unacceptable for the hedge fund manager from a tax perspective. Also, the “switch” facilitates distributions from the policy on a tax-free basis. . The Family Trust issues a promissory note to the offshore corporation. The promissory note is equal to the policy’s cumulative premiums. The note has an interest equal to the long-term applicable federal rate or AFR (currently 2.34%).
Phase 3- Loan Phase – The loan interest accrues and is added to the principal of the loan. The family trust owns the policy in its entirely. The trustee of the family trust is able to take a partial surrender of the cash value and policy loans to make tax-free payments each year to the hedge fund manager and trust beneficiaries.
Phase 4- The End – The loan and any accrued interest is repaid at the hedge fund manager’s death to the offshore corporation. Pursuant to the DBO Plan, the corporation uses the repaid loan proceeds to make the payments on a taxable basis to the trial attorney’s estate or beneficiaries.
Split Dollar Overview
Split dollar life is a contractual arrangement between two parties to share the benefits of a life insurance contract. In a corporate setting, split dollar life insurance has been used for 55 years as a fringe benefit for business owners and corporate executives. Generally speaking, two forms of classical split dollar arrangements exist, the endorsement method and collateral assignment method. Importantly, IRS Notice 2007-34 provides that split dollar is not subject to the deferred compensation rules of IRC Sec 409A. See § 1.409A-1(a)(5).
The IRS issued final split dollar regulation in September 2003. These regulations were intended to terminate the use of a technique known as equity split dollar. The consequence of these regulations is to categorize into two separate regimes – the economic benefit regime or the loan regime.
Split Dollar under the Economic Regime
Under the economic benefit regime, the employee or taxpayer is taxed on the “economic benefit” of the coverage paid by the employer. The tax cost is not the premium but the term insurance cost of the death benefit payable to the taxpayer. The economic benefit regime usually uses the endorsement method but may also use the collateral assignment method.
In the endorsement method within a corporate setting, the corporation is the applicant, owner and beneficiary of the life insurance policy insuring a corporate executive. The company is the applicant, owner, and beneficiary of the life insurance policy. The company pays all or most of the policy’s premium. The company has in interest in the policy cash value and death benefit equal to the greater of the policy’s premiums or cash value. The company contractually endorses the excess death benefit (the amount of death benefit in excess of the cash value) to the employee who is authorized to select a beneficiary for this portion of the death benefit.
Under the collateral assignment method, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employee collaterally assigns an interest in the policy cash value and death benefit equal to the greater of the cash value or cumulative premiums.
The economic benefit is measured using the lower of the Table 2001 term costs or the insurance company’s cost for annual renewable term insurance. This measure is the measure for both income and gift tax purposes. Depending upon the age of the taxpayer, the economic benefit tax cost is a very small percentage of the actual premium paid into the policy -1-3 percent.
Split Dollar Under the Loan Regime
The loan regime follows the rules specified in IRC Sec 7872. Under IRC Sec 7872 for split dollar arrangements, the employer’s premium payments are treated as loans to the employee. If the interest payable by the employee is less than the applicable federal rate, the forgone interest payments are taxable to the employee annually. In the event the policy is owned by an irrevocable trust, any forgone interest (less than the AFR) would be treated as gift imputed by the employee to the trust. The loan is non-recourse. The lender and borrower (employer and employee respectively) are required to file a Non-Recourse Notice with their tax returns each year (Treas Reg. 1. 7872-15(d) stating that representing that a reasonable person would conclude under all the relevant facts that the loan will be paid in full.
Split dollar under the loan regime generally uses the collateral assignment method of split dollar. In a corporate split dollar arrangement under the loan regime, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employer loans the premiums in exchange for a promissory note in the policy cash value and death benefit equal to its premiums plus any interest that accrues on the loan. The promissory note can provide for repayment of the cumulative premiums and accrued interest at the death of the employee.
Switch dollar is a method of split dollar life insurance that commences using the economic benefit method and then converts to the loan regime when the economic benefit costs become too high.
Death Benefit Only (DBO) Plan Overview
The DBO Plan is a contractual arrangement between a corporation and an employee or contractor. The corporation agrees that if the contractor or employee dies, the corporation will pay a specified amount to the employee or contractor’s spouse or other designated class of beneficiaries’ children. Payments can be made on an installment basis or in a lump sum.
The payments are taxable income but can be structured so that the payments are estate tax-free. If the payments are made to a designated beneficiary that does not provide the employee with the ability to right to change or revoke the beneficiary designation, the payments can avoid estate taxation. My planning suggestion is to have the designated beneficiary as the hedge fund manager’s family trust. The hedge fund manager will not have a general power of appointment over the trust that could result in estate tax inclusion.
IV Strategy Example
Joe Smith, age 50, is the managing member of Acme Funds, a hedge fund. Acme is a $1 billion fund with assets equally split between the onshore and offshore funds. The fee structure for fund provides for a two percent management fee and 20 percent carried interest. The fund earns 10 percent in 2012. The expected carried interest for the offshore fund is $10 million. Joe typically splits half the carried interest with his managing directors and key traders.
Acme’s offshore fund, a BVI corporation, enters into a split dollar arrangement with Acme Investment Management, and the Smith Family Trust. Under the arrangement, Acme agrees to pay premiums equal to one-quarter of the carried interest calculation or $2.5 million as a premium in the split dollar arrangement. Under the arrangement, Acme will have a collateral assignment interest in the policy equal to the greater of the policy cash value or policy’s cumulative premiums. Acme’s access to the cash value is restricted under the arrangement until the earlier of the termination of the split dollar agreement, surrender of the policy or death of the insured, Joe Smith.
The Smith Family Trust is an irrevocable trust designed to provide multi-generational benefits to Joe’s wife, children and grandchildren. The trustee of the family trust is the applicant, owner, and beneficiary of a private placement life insurance policy insuring Joe’s life. The policy will have premiums of $2.5 million per year or whatever the calculated carried interest equivalent in a particular year might be. The policy will have a death benefit of $45 million.
During the first ten years of the arrangement, the split agreement will use the economic benefit arrangement and then switch to the loan regime. The cumulative tax costs over the ten year funding period for income and gift tax purposes $437,000 which is 1.7 percent of the premiums paid into the policy by the offshore corporation.
Projection of Tax Costs
Year Income Tax Gift Tax Cum. Premiums Cum. Income Tax
1 $32,400 $32,400 $2.5 million $32,400
5 $40,950 $40,950 $12.5 million $181,800
10 $58,050 $58,050 $25 million $436,150
At the end of Year 10, the trustees agree to switch to the loan regime. The trustees terminate the collateral assignment agreement in exchange for a promissory note equal to the cumulative premiums paid to date, $25 million. The cash value in the policy at the end of Year 10 is $37.5 million assuming an 8 percent net return. The death benefit is $81 million. The interest rate on the loan is the long-term AFR which is 3 percent per year.
The interest is capitalized and added to the promissory note. The annual interest charge added to the policy is $1 million in Year 11. Ultimately, a portion of the death benefit equal to the accumulate principal and interest will be repaid to the Offshore Corporation. These repayments will be paid to Joe’s wife and family in a lump sum or on installments.
The trustee of the Smith Family Trust takes a tax-free policy loan of $1 million per year beginning in Year 10 and distributes the proceeds to Mrs. Smith who is a discretionary beneficiary of the Trust. The distribution is also tax-free.
In the event of Joe’s death, the proceeds, $25 million plus any accrued interest, is paid to the offshore corporation to fund the DBO Plan. The Plan calls for a lump sum payment to the Family Trust. The payment is subject to income taxation but not estate taxation.
The excess death benefit, $45 million or more is payable to the Family Trust on an income and estate tax free basis.
The strategy outlined above provides powerful tax benefits to hedge fund managers in the wake of IRC Sec 457A. The combination of plans – split dollar and DBO- are traditional strategies with a lot of statutory authority and case law support. Hedge fund managers receive minimal taxation during the funding of the program and have the ability to turn the “carried interest” equivalent into income and estate tax-free benefits.
In many respects, this plan is superior to existing “Super IRA” version of offshore carried interest that is now subject to IRC Sec 457A. Those benefits are subject to both income and estate tax.
The second installment of this series will focus on a few advanced strategies to migrate the benefit entirely to a family trust in the event the hedge fund is liquidated or sold.